Default rates for loans guaranteed by the Federal Housing Administration have historically been higher than those for loans guaranteed by the Department of Veterans Affairs. New research from the Urban Institute suggests that a key difference in the way programs measure a borrower’s ability to pay could explain much of this performance gap.
Both government-backed programs are essential for first-time home buyers and low-income buyers because they allow for minimum down payments. FHA borrowers can deposit as little as 3.5% of the loan amount, while the VA, which is limited to veterans and active duty military personnel, allows 100% funding.
Institute researchers compared the performance of the FHA and VA for mortgages taken out between 2000 and 2012, and found that the cumulative default rate over the life of the loans to date has been consistently higher. for FHA loans in each of the years, the gap widening from 2005 to mid-2007.
In the inception year 2007, for example, the worst for the FHA, 36% of loans were 90 days or more past due. In contrast, the default rate for VA loans that year was 16%.
Even when researchers looked at loans from borrowers with similar incomes, credit scores, and mortgage burdens, VA loans still performed better.
The study highlights two structural differences that could explain the performance of VA. One is the level of responsibility of the lender. VA loans are guaranteed for a maximum of 25% of the loan amount; FHA loans come with a 100% guarantee. The other difference concerns the subscription. In addition to measuring the debt-to-income ratio, the VA uses a “residual income” test. Borrowers must show a certain level of income after mortgage payment, taxes, utilities, and employment-related expenses (such as child care) are subtracted from gross monthly income.
Minimum residual income levels are set according to family size and region. In the Northeast, on loan amounts of $ 80,000 or more, a household of two must have at least $ 755 of monthly residual income; for four, the minimum is $ 1,025.
“We think residual income is probably more important than risk sharing,” said Laurie Goodman, director of the Urban Institute’s housing finance policy center, “but it’s actually extremely difficult to disentangle” .
She estimated that the FHA could potentially reduce defaults by up to 20% if it included the residual income test. Using the debt-to-income ratio alone doesn’t really measure whether a borrower will have enough excess income to cover living expenses, she added.
This can be a crucial difference for low income borrowers. For example, two borrowers might each have mortgage debt of 40% of their income, but the one with income of $ 60,000 will have a lot more money each month to cover living expenses than the one with income of $ 30,000. .
Geoffry Walsh, an attorney at the National Consumer Law Center, noted that in January, the HUD passed a new FHA guideline that allows lenders to use the residual income formula as an alternative way to qualify borrowers who exceed the threshold. debt standard. .
But Ms. Goodman says using the formula in this way doesn’t exclude marginal borrowers; instead, it allows high-income borrowers to purchase homes that are more expensive than they might otherwise be eligible for.
Richard Morris, vice president of investor relations and equity lending for the Navy Federal Credit Union, which made $ 5.7 billion in VA loans last year, said the drop in the default rate is also attributable to the tendency of military borrowers to “take their financial obligations very seriously.” . “